“Everything should be made as simple as possible, but not simpler” Albert Einstein

The Federal Government announced a number of significant superannuation reforms in the 2016 Federal Budget in an attempt improve the integrity, sustainability and flexibility of the superannuation system. However, in order to achieve this outcome, a degree of complexity has been applied to the system, moving away from the Simpler Super reforms of 2007.

Many of these changes are set to take effect from 1 July 2017, however despite the significant media coverage on the reforms, so much uncertainty remains.

With just on 3 months until “go live”, the industry (including superannuation Trustees, financial advisors, super and pension members, administration and software service providers, to name a few) is still scrambling to understand and implement some of the more complex reforms announced.

Within this article, I am not going to discuss all of the changes, but only three measures which are causing particular angst and confusion across both industry players and superannuation members. Let’s take a look at these in a little more detail:

1. The introduction of a transfer balance cap to limit the amount that can be transferred to a retirement phase income stream

2. Individuals with a total super balance above a certain threshold will not be eligible to make a non-concessional contribution to their super

3. Transition to Retirement Income Streams (TTRs) will no longer be classified as a retirement phase income stream for tax purposes

We’ll also see how these tie together and affect superannuation reporting obligations to the ATO.

Introducing the transfer balance cap

Of all the changes, this one is arguably the most complex, far-reaching and has gained the most attention. At a high-level, this is a cap on the amount that an individual can transfer into a retirement phase income stream (pension account). For the 2017/18 financial year, the transfer balance cap has been set at $1.6m, but is subject to indexation in future financial years in $100,000 increments to align with CPI.

How will this work?

Every pension member will have a Transfer Balance Account attributed to them by the ATO which, using a system of credits and debits (similar to the way a general ledger operates), will track how much cap an individual has used across all of their superannuation funds. A credit to the Transfer Balance Account signifies that cap is being used-up, whereas a debit frees-up cap space.

From 1 July 2017, most transfers into a pension product count as a credit toward an individual’s transfer balance cap, whereas any lump sum withdrawals from the pension are counted as a debit against the cap.

A credit toward the cap will primarily occur whenever a new pension account is opened, with the value of the initial deposit counting as the credit against the cap.

Anyone with an existing retirement income stream on 30 June 2017 will also fall under the new rules, with their closing balance at 30 June 2017 counting as the credit toward their cap effective 1 July 2017.

A debit will occur for any commutation paid from the pension, whether paid back to a superannuation account or directly to the individual. Debits include ALL full and partial commutations, which includes payments resulting from a family law split, as well as ad hoc requests from the ATO to cover instances such as fraud, bankruptcy, or other transactions as necessary. These transactions all “free-up” transfer balance cap space.

It’s important to note that any investment returns (positive or negative) and regular pensiondrawdownsdo not count toward the transfer balance cap.

To be clear, only specific transactions count toward the transfer balance cap, whereas a pension account balance will fluctuate on a daily basis with fees, pension payments, investment returns and other transactions applied, and may even fluctuate over the $1.6m threshold at any point. These incidental transactions will not result in an excess transfer balance.

What happens if someone exceeds the transfer balance cap?

When an individual member exceeds the cap, they MUST remove the additional amount, PLUS the notional earnings they have accrued on the amount since the excess arose, either back to super or as a lump sum withdrawal. The notional earnings are determined using a rate set within the legislation, and therefore not linked to the investment returns applied by the superannuation fund.

In addition to removing the excess amount, the ATO will issue a tax bill to the individual to capture the tax that was unpaid while the funds were unduly invested within the tax-free pension phase.

This might be a good time to run through a few simple examples.

Example 1: John opens a pension account with $850,000 on 1 April 2017. At 30 June 2017 his pension account was valued at $900,000. Because John had an existing pension account on 30 June 2017, a credit of $900,000 (his account balance) is applied as a credit against his cap effective 1 July 2017. John has used $900,000 of his allotted $1.6m transfer balance cap.

Example 2: John opens a second pension account on 1 October 2017 for $300,000. As this pension was created after 1 July 2017, a credit of $300,000 is applied against his transfer balance cap, taking the total value of his transfer balance account to $1,200,000 (900,000 + 300,000).

Example 3: John decides to take a partial commutation from one of his pension accounts of $200,000 on 1 December 2017. A debit of $200,000 is applied against his transfer balance cap, taking the total value of his transfer balance account to $1,000,000 (1,200,000 – 200,000).

Note that, apart from John’s initial pension transfer at 30 June 2017, his pension account balance and any incidental transactions do not affect how much transfer balance cap has been utilised.

A consequence of this change is that partial commutations from a pension account will no longer count toward an individual’s minimum drawdown requirements. This is a necessary change to prevent individuals from taking their full minimum annual pension as a partial commutation, thereby incurring a debit and “freeing-up” cap space.

Unfortunately, this measure becomes significantly more complicated when the concept of a “personal transfer balance cap” is introduced, which is exactly what can (and will) occur. A personal transfer balance cap refers to the amount of transfer balance cap that applies to an individual member and is based on the specific transactions that occur within that member’s pension account/s.

There are two scenarios that will give rise to this:

1. Full commutation:

When a full commutation is processed, the full account balance commuted counts as a debit against the transfer balance cap. In situations where the account balance has grown higher than the amount of transfer balance cap utilised, this can take the transfer balance account into a negative balance.

Technically, this allows an individual to create a new pension for more than the transfer balance cap.

Example 4 – full commutation:John has used $1m of his $1.6m transfer balance cap. On 1 March 2018, John fully commutes all of his pension accounts back to super which total $1.1m. On this date, a debit of $1.1m is applied against his transfer balance cap, taking the value of his transfer balance account to $-100,000.

This means that when John wants to start a new pension, he can transfer up to $1.7m without penalty.

2. Proportional indexation

As noted above, the transfer balance cap is indexed in increments of $100,000 in line with CPI. However, unlike other superannuation cap limits, an individual is only entitled to a proportion of the transfer balance cap indexation based on the amount of cap they have previously used.

Proportional indexation is designed to hold the amount of used and unused cap space constant as the transfer balance cap increases. The amount of indexation that applies is calculated by determining the highest amount of transfer balance used and expressing the unused portion as a percentage. This percentage of unused cap is the amount of indexation that will be applied.

Example 5 – proportional indexation:assume the transfer balance cap is due to be indexed to $1.7m on 1 July 2018. Since the introduction of the transfer balance cap, the highest amount of cap that John has utilised is $1.2m which is 75% of the available cap at the time, leaving 25% of cap space free. This entitles John to 25% of the indexation amount. Effective 1 July 2018, John’s transfer balance cap is increased to $1.625m.

Note – following from Example 4, John still has a negative balance in his transfer balance account of $-100k, so technically from 1 July 2018 John could transfer up to $1.725m into a pension account.

So the big question is: how are super funds going to manage these new rules?

Short answer, they’re not. The reliance will be on the funds to capture and report the applicable transactions to the ATO so that the ATO can collate the data and liaise directly with the member if necessary. Significant enhancements to the current fund reporting mechanisms will need to be made to facilitate this.

The only obligation that superannuation funds will have regarding this new measure is to comply with a release authority issued by the ATO to rectify any retirement phase income streams that exceed the transfer balance cap.

Commensurate measures have been introduced for defined benefit pensions and other non-commutable schemes where an individual cannot withdraw any excess transfer balance. Instead, additional taxation will apply to these high balance accounts. Child pensions and reversionary beneficiaries will also be affected by this new cap, with varying ramifications.

Restricting non-concessional contributions based on account balance

In addition to lowering the annual and bring-forward non-concessional contribution caps to $100,000 and $300,000 (respectively), the government have also imposed a maximum account balance threshold at which an individual’s non-concessional cap reduces to nil. This maximum account balance is the general transfer balance cap which, as noted above, is $1.6m for the 2017/2018 financial year. This measure also introduces the concept of a “Total Superannuation Balance” (TSB).

DIAGRAM: Total Superannuation Balance (TSB)

So how does this work? Where an individual’s TSB equals or exceeds the general transfer balance cap at 30 June, their non-concessional cap for the following financial year is reduced to $0. This restricts the individual from making a non-concessional contribution at any time within that financial year, irrespective of any prior action such as triggering the bring-forward provisions. In addition, if their TSB is nearing the general transfer balance cap, their caps for the following year may be impacted. - See more at: http://www.qmvsupersolutions.com/qmv-super-smarts/fair-and-sustainable-the-governments-2017-superannuation-changes-explained/#.WPVqo1N95Bw

A consequential change as a result of this measure is that the fund-capped contribution limit has been removed, enabling a super fund to accept a non-concessional contribution of any value without being required to refund the excess.

Are super funds expected to manage this process?

No, a super fund will not know what their member’s TSB is, nor what contributions have been made to other super funds and therefore be unable to manage any processes around contribution acceptance.

Transition to Retirement income streams no longer in retirement phase

One of the more controversial changes announced within the Budget was the re-classification of TTR income streams from a retirement phase income stream to a superannuation income stream. This change is likely to have a more widespread effect than the above measures.

What is the relevance of this change?

Currently, retirement phase income streams (i.e. pensions) receive a tax exemption for any income earned on the underlying assets funding the income stream. By re-classifying TTRs from a retirement phase income stream to a superannuation income stream, this tax exemption no longer applies, which requires all earnings to be taxed at a concessional rate of 15% (or less for some capital gains).

There’s been quite a lot of discussion around whether this change makes TTRs viable or if they’ve become a redundant product. For those individuals legitimately seeking to access their super while still working (in accordance with the original intent of TTRs when they were introduced in 2005), TTRs remain as important as ever, albeit with reduced tax incentives.

However, using TTRs to reduce the income tax and superannuation earnings tax payable will likely become a less attractive practice, given there will be no difference in tax payable whether the funds are invested in a superannuation account or a TTR.

This change is just as significant for super funds as it is for their members, perhaps more so. The way that taxation is applied to investment returns varies across funds and will depend on whether the super and pension assets are segregated or pooled, and will also depend on whether gross or net investment returns are allocated to individual investors by the fund.

Superannuation funds are currently working through the options available to them to understand the impacts across the organisation, from fund accounting, taxation, unit pricing and investment operations.

ATO Reporting

With the ATO playing such a central role, the key question is: how will all of this new information be reported to the ATO in a timely manner? The current Member Contribution Statement (MCS) and PAYG withholding reporting obligations are likely to be insufficient given they are only performed on an annual basis.

Prior to the announcement of the fair and sustainable reforms, the ATO had commenced discussions with the industry on the Member Information Exchange (MiX) – a new portal that would allow “real-time” reporting of Lost members, Unclaimed monies and would also replace MCS reporting. Given the subsequent announcement of the super reforms, the discussions around the MiX have now expanded in scope to include a “Retirement Phase Report” to capture transactions affecting the transfer balance cap.

Although this sounds reasonable in theory, there are many questions and doubts on the feasibility of implementing such a significant change by the planned November 2017 release of MiX. Further, given the commencement of these measures in July 2017, this leaves a gap in the reporting timeline. Specific information will need to be reported to the ATO earlier to enable individuals to make an informed decision regarding their financial position for the 2017/2018 financial year.

To date, there is very limited information available as to what the MiX will require and no specifications have yet been released to enable superannuation funds to prepare for this significant change.

So where to now?

The mantra across the industry seems to be education and communication. The onus is on the individual to understand their situation in accordance with the new rules and take appropriate action if they are impacted. However, super funds are obviously very keen to ensure their members are in the best position to make this determination, which may require a significant increase to the current level of communications and education material provided.

Clearly, superannuation funds are going to be very busy over the coming months to ready themselves and their members for these changes. All funds should have already conducted member segmentation and be in the process of issuing targeted communication to each cohort based on age and/or account balances, while financial planners should be re-reviewing their client’s plans to see what changes need to take place.

Back-office systems will require configuration changes, fund accounting and taxation processes will need to be updated, significant changes will be required to all customer-facing fund communication, including Product Disclosure Statements (PDS’), member statements, forms, fact sheets, information flyers, the website and member online portal. Internal fund materials will also require significant changes, including scripting for the call centre, reporting enhancements, training material, process guides, and even changes to regulatory material and fund rules.

Given these changes have generally been made across the super system and are not isolated within one super fund, there is not a lot that funds can do to ensure their members are compliant. Super funds will have limited to no visibility on their member’s overall situation and therefore not in a position to restrict or reject certain transactions from occurring.

To counteract this, many funds are implementing new system warnings and additional exception reporting at an account level to identify any of their members who may be nearing certain caps or have high balances within the fund. These warnings are simply designed to trigger a conversation with the member.

Given the vast nature of the changes, the wide-spread impacts are causing significant implementation issues for many industry players, from simply trying to understand what the changes are, to what solution needs to be put in place. As the 1 July 2017 deadline moves ever closer, the pressure continues to mount.

QMV Solutions is well positioned to assist with any challenges you may be experiencing with the implementation of these reforms. If you would like to discuss how we can help, please contact us for a preliminary discussion.